Variable consideration as a term is self-explanatory; any consideration that has a variable component whether stated or implied in the contract. Practical application of this definition is not as straight forward. Variable consideration can come in many forms such as discounts, rebates, price concessions, refunds, rights of return, and so on that must be assessed as part of Step 3: Determine the Transaction Price. Consideration may be stated in the contract for example as being contingent upon a future event such as a feature release, or implied as a part of standard business practice such as customarily providing credits to customers.
As the variability does not allow for a stated transaction price, an entity must estimate using one of two methods:
Expected Value Method:
An expected value assessment is probability based. There are a range of outcomes that could be realized, and a probability based on some historical data or other known facts that each outcome could occur.
Expected Value Example:
Entity A sells a usage based service X to their B2B customers.
Customer B has contracted to use a minimum of 1,000 units of service X within the calendar year for a flat fee of $10,000.
If usage is over 1,000 units, additional consideration is owed as follows:
* 1,001 and 2,000: $5 / unit; 2,001–3,000: $3.50 / unit; 3,001–4,000: $2.50 / unit; 4,001 and over: The contract will be re-negotiated
Based on historical data, similarly situated customers have indicated the following usage probabilities:
* 0–1,000: 15%; 1,001–2,000: 75%; 2,001–3,000: 7%; 3,001–4,000: 3%; >4,000: less than 0.001%
Therefore, we will assess our Transaction Price using the midpoint of each tier (for simplicity in the example) as follows:
* (15% * $10,000) + (75% * $12,500) +(7% * $16,750) +(3% * $19,750) = Transaction Price: $12,640
Most Likely Amount Method:
A most likely amount assessment estimates the transaction price based on the single most likely amount in a range of possibilities.
Most Likely Example:
Consider the same facts in the expected value example with the following changes:
If usage is over 1,000 units, additional consideration is owed to Entity A a flat fee as follows:
* 1,001 and 2,000: $5,000; 2,001–3,000: $3,500; 3,001 and over: $2,500
Based on historical data, similarly situated customers have provided the following usage probabilities:
* 0–1,000: 15%; 1,001–2,000: 75%; 2,001–3,000: 7%; 3,001 and over: 3%
Therefore, given that the most likely scenario is that the customer uses between 1,001 and 2,000 units, our Transaction Price is $15,000
It is worth noting that methods to come up with the most likely amount have been more heavily scrutinized by the SEC than the expected value.
The Constraint to Variable Consideration
Once the transaction price has been determined based on one of the two methods illustrated above, the entity must assess any constraint to variable consideration. To paraphrase the guidance in 606–10–32–11: An entity shall include in the transaction price some or all of an amount of variable consideration estimated… only to the extent that it is probable that a significant reversal…of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is subsequently resolved.
That is a mouthful that can for the most part be practically applied as: if it is probable that there will be a significant reversal of revenue recognized to date upon resolution of the variable consideration constraint, the variable consideration should not be factored into the transaction price.
Constraint to Variable Consideration Example:
Consider the same facts in the most likely example with the following changes:
Based on historical data, similarly situated customers have indicated the following usage probabilities:
* 0–1,000: 25%; 1,001–2,000: 25%; 2,001–3,000: 25%; 3,001 and over: 25%
Given that it is equally likely that each of these scenarios could come to fruition, the value of the transaction price could range from $10,000 — $21,000. Therefore, if we assessed the transaction price at $15,000, it is likely that there will be significant reversal of revenue recognized to date should the customer only use 1,000 units before the end of the year.
Therefore, in this scenario, we would conclude that the variable consideration is constrained and recognized revenue based on a $10,000 transaction price.
Once the constraint is lifted, the entity can re-assess the transaction price.
Factors that increase the probability of a significant reversal are:
- The amount of consideration is highly susceptible to factors outside the entity’s influence, including volatility in a market, the actions of third parties, or weather / other natural phenomena.
- The uncertainty is not expected to be resolved for a long period of time such as an event that could take place any time in a 10 year contract.
- The entity’s experience with similar types of contracts is limited, or that experience has limited predictive value.
- The entity has a practice of either offering a broad range of price concessions or changing the payment terms of similar contracts.
- The contract has a broad range of possible consideration amounts.
Variable consideration specifics range widely, and the scenarios discussed here are not all-inclusive. Each entity must assess the particular facts and circumstances as needed for their organization and come to a conclusion that makes the most sense.
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